PLANNING AND ADMINISTERING ESTATES AND TRUSTS: THE INCOME TAX CONSEQUENCES YOU NEED TO CONSIDER

Transcription

1 PLANNING AND ADMINISTERING ESTATES AND TRUSTS: THE INCOME TAX CONSEQUENCES YOU NEED TO CONSIDER Theodore B. Atlass ATLASS PROFESSIONAL CORPORATION Denver, Colorado (303) Mickey R. Davis DAVIS & WILLMS, PLLC 3555 Timmons Lane, Suite 1250 Houston, Texas (281) Melissa J. Willms DAVIS & WILLMS, PLLC 3555 Timmons Lane, Suite 1250 Houston, Texas (281) ACTEC-ALI CLE PHONE SEMINAR MAY 9, 2013

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3 PLANNING AND ADMINISTERING ESTATES AND TRUSTS: THE INCOME TAX CONSEQUENCES YOU NEED TO CONSIDER I. INTRODUCTION... 1 II. INCOME TAX CONSEQUENCES OF NON-CHARITABLE GIFTS AND LOANS... 1 A. Income Shifting Benefits Are Limited Relevant Factors Shifting Income To Trust Kiddie Tax Rules Section 529 Plans... 1 B. Income Tax Consequences Of Gifts To The Donor Post-Gift Income Unrealized Gain Below-Market Loans Gain from "Net Gift" Transactions Gain from Assumption of Non-Recourse Debt Gift of Installment Obligation Gift of Passive Loss Assets... 2 C Income Tax Consequences of Gifts To The Donee No Income Tax on Gifts or Bequests Taxation of Post-Gift Income Taxation of Post-Death Income Taxation of Forgiveness of Indebtedness... 2 D. Adjusted Basis Of Gifted Property Carry-Over Basis Basis for Gift Tax Paid Basis for GST Tax Paid Basis of Suspended Passive Losses Limitation on Basis for Loss Purposes... 3 E. Loans to Family Members Below-Market Loan Rules Loans Under $10, Loans Under $100, Investment Income Limitation Loans at "Applicable Federal Rate" of Interest... 3 III. INCOME TAX CONSEQUENCES OF RELATED PARTY TRANSACTIONS... 3 A. Who is a Related Party?... 3 B Section 1031 Exchanges Between Related Parties... 4 C Sales of Depreciable Assets to Related Party D. Sale of Depletable Property to Related Party... 4 E. Appreciated Property Acquired By Decedent By Gift Within One Year of Death F. Disallowance of Losses on Sales between Related Parties G. Guarantee of Loans to Related Parties H. Installment Sale to Related Party I. Non-Recognition of Gain or Loss Between Spouses... 5 J. Transfer for Value of Life Insurance... 5 IV. PRE-DEATH INCOME TAX PLANNING... 5 A. Capture Capital Losses... 5 B. Transfer Low Basis Assets to the Taxpayer Gifts Received Prior to Death.... 5

4 2. Granting a General Power C. Transfer High Basis Assets to Grantor Trust... 6 D. Change Marital Property Characteristics Partition Depreciated Community Property Transmute Appreciated Separate Property E. Dispose of Passive Loss Assets... 6 F. Pay Medical Expenses... 7 G. Accelerate Death Benefits Payments to Terminally Ill Taxpayers Payments to Chronically Ill Taxpayers... 7 V. INCOME TAXATION OF DECEDENTS AND ESTATES... 8 A. The Decedent's Prior Tax Returns Ascertaining What Tax Returns Have Been Filed Ascertaining the Amount of the Decedent's Income Getting Copies of Prior Filed Tax Returns Contact Area Disclosure Officer... 8 B. The Decedent's Final Return Due Date, Filing Responsibilities, and "Short Year" Issues "Fiduciary Liability" Transferee Liability Priority of Tax Claims Claims for Refund Place for Filing Decedent's Final Return Applicable Statute of Limitations Filing Joint Returns Planning Opportunities on the Final Return C. The Estate's Income Tax Return Obtaining an Employer Identification Number Notifying the IRS of Fiduciary Status Electing a Fiscal Year End Passive Activity Losses Allocating Depreciation D. Ten Things Estate Planners Need to Know About Subchapter J Estate Distributions Carry Out Distributable Net Income An Estate May Recognize Gains and Losses When It Makes Distributions In Kind Estate Beneficiaries May Recognize Gains and Losses If the Estate Makes Unauthorized Non Pro Rata Distributions In Kind Income in Respect of a Decedent is Taxed to the Recipient Impact of Death Upon Basis The Executor Can Elect to Deduct Many Expenses for Either Income or Estate Tax Purposes (but not Both) Post-Death Revocable Trusts May Be Separate Taxpayers or Part of the Estate When An Estate or Trust Allocates "Income," That Means Fiduciary Accounting Income, Not Taxable Income Deduction of Interest Paid on Pecuniary Bequests Non-Pro Rata Divisions of Community Property VI. ADDITIONAL INCOME TAX ON ESTATES AND TRUSTS A. Health Care and Education Reconciliation Act of 2010, P.L B. IRC Net Investment Income vs. Undistributed Net Investment Income Trade or Business C. Proposed Regulations D. Trusts E. Grantor Trusts F. Special Problem Areas... 34

5 1. Capital Gains Qualified Subchapter S Trusts ( QSSTs ) Passive Loss Rules Charitable Remainder Trusts Properly Allowable Deductions G. Special Notes Estates of Decedents Dying in Tax Does Not Apply to Distributions from Qualified Plans Nonresident Aliens H. Planning for the Tax VII. STATE INCOME TAXATION OF TRUSTS A. Constitutional Issues The Nexus Requirement Contacts Supporting State Taxation Broader Views of Contacts Interstate Commerce Issues B. State Tax Regimes Resident vs. Non-Resident Trusts Determining Trust Residency Income Derived from Within the State C. Selecting a Trust Situs to Avoid State Tax VIII. OVERVIEW OF INCOME TAXATION OF FLOW-THROUGH ENTITIES A. Partnerships Entity Not Taxed Taxation of Partners Basis Issues B. S Corporations Qualification Entity Not Taxed Basis Issues Ownership By Trusts and Estates C. Limited Liability Companies IX. INCOME TAX ISSUES ASSOCIATED WITH FLOW-THROUGH ASSETS A. Issues Unique to Estates Basis and the Section 754 Election Fiscal Year End Issues Requirement to Close Partnership and S Corporation Tax Years Special Problems for Estates Holding Interests in S Corporations Income Tax Consequences of Funding Bequests with Partnership Interests and S Corporation Stock B. Trust Issues Distribution of "All Income" Trapping Distributions Cash Flow Difficulties X. CONCLUSION... 47

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7 ESTATE AND TRUST INCOME TAX ISSUES 1 PLANNING AND ADMINISTERING ESTATES AND TRUSTS: THE INCOME TAX CONSEQUENCES YOU NEED TO CONSIDER I. INTRODUCTION It is essential for estate planners to have a fundamental understanding of the income taxation of trusts and estates, and of the income tax issues that arise in relation to related-party transactions. The income tax arena presents a multitude of planning opportunities that arise, both during lifetime, and during the administration of a trust or a decedent's estate. The goal of this outline is to focus essential income tax planning issues that arise (i) as a result of intra-family transactions; (ii) immediately before death; and (iii) when administering the estate of a decedent. The outline addresses critical income tax reporting issues that arise for estates and trusts. An exhaustive examination of the issues would result in a book-length outline (or a semester-long course in law school). This outline is intended to hit some of the highlights in the area of income tax planning and reporting for family members, trusts and estates. II. INCOME TAX CONSEQUENCES OF NON-CHARITABLE GIFTS AND LOANS A. Income Shifting. 1. Benefits are Limited. Income shifting will save only small amounts of income taxes today, which is a huge change from the estate planning practice in the 1970's and '80's, due to rate reduction, bracket compression, expanded kiddie tax rules, prohibitions against multiple trusts, and the elimination of many income shifting devices (Clifford trusts, Rushing trusts, spousal remainder trusts, etc.). 2. Relevant Factors. Many factors besides bracket differential may impact the amount of tax savings achieved through income shifting, including the kiddie tax rules, the percentage limitations on various deductions (medical expenses, charitable deductions, casualty losses, miscellaneous itemized deductions, etc.), the partial disallowance of itemized deductions impacting high income taxpayers, capital and net operating loss carry-forwards, phase out of the $25,000 real estate exception to the passive activity loss rules, alternative minimum tax consequences, etc. 3. Shifting Income to Trust. Income taxed to a trust in excess of $11,950 for tax years beginning after December 31, 2012 will be taxed at the highest marginal income tax bracket (i.e., 39.6%), and trusts get only a $100 or $300 allowance in lieu of personal exemption, so little federal income tax savings will result from shifting taxable income from even a highest bracket individual taxpayer to a trust with no other income. 4. Kiddie Tax Rules. The kiddie tax rules have been expanded and now apply to children who are under 19 and dependent full-time students who are under age 24. For 2013, a child having only investment income will not pay income tax on the first $1,000 of such income and will pay income tax at the child s rate on the next $1,000 of investment income, with any excess taxes at the parents' rate. IRC 1(g). 5. Section 529 Plans. Income earned in a Section 529 Plan that is subsequently spent on qualifying educational expenses will never be taxed to anyone. IRC 529. B. Income Tax Consequences of Gifts To The Donor. 1. Post-Gift Income. Any income generated on gifted property after the date of the gift is shifted from the donor's income tax return to the donee's income tax return. 2. Unrealized Gain. Any unrealized gain in appreciated gifted property becomes the donee's problem (as the donee receives a carryover basis) unless the gift itself is characterized as a taxable disposition triggering gain to the donor (such as in the case of a gift of an installment obligation).

8 2 ACTEC-ALI CLE PHONE SEMINAR MAY 9, Below-Market Loans. Gift loans (i.e., those containing a below-market rate of interest) cause the lender to have imputed interest income for income tax purposes, subject to a de minimis rule. IRC Gain from "Net Gift" Transactions. Where a "net gift" is made (i.e., the gift taxes on the transfer, which are the legal obligation of the donor, are instead assumed by the donee as a condition of the gift), the donor will realize gain to the extent the gift tax paid exceeds the donor's adjusted cost basis in the property. Diedrich v. Comm'r, 643 F.2d 499 (8th Cir. 1981). Example: Assume that a donor has no remaining exclusions or unified credit, and is in a flat 40% gift tax bracket. If a $1 million asset having no cost basis was given away in a net gift transaction (i.e., the donee was to pay any gift tax due), then a net gift of $714,286 would be made by the donor. The donee would pay the donor s $285,714 gift tax liability, which would be "boot" to the donor. The donor would have $285,714 of gain (i.e., the amount of boot in excess of basis). 5. Gain from Assumption of Non-Recourse Debt. Where a gift is made of property subject to nonrecourse indebtedness, the donor will realize gain to the extent that indebtedness exceeds the basis of the property. Winston F. C. Guest, 77 T.C. 9 (1981). The "amount realized" is equal to the outstanding balance of the nonrecourse obligation, and the fair market value of the property is irrelevant to the computation. Tufts v. Comm'r, 103 S.Ct 1826 (1983). 6. Gift of Installment Obligation. The transfer of an installment obligation by lifetime gift will constitute a disposition and cause an acceleration of the deferred gain for income tax purposes. IRC 453B. 7. Gift of Passive Loss Assets. The transfer of a passive-activity asset by lifetime gift does not trigger the recognition of suspended passive activity losses. IRC 469(j)(6). C. Income Tax Consequences of Gifts To The Donee. 1. No Income Tax on Gifts or Bequests. Gross income does not include the value of property acquired by gift, bequest, devise or inheritance. IRC 102(a). 2. Taxation of Post-Gift Income. Gross income does include the income derived from any property acquired by gift, bequest, devise or inheritance. IRC 102(b)(1). 3. Taxation of Post-Death Income. Gross income does include the amount of such income where the gift, bequest, devise or inheritance is of income from property. IRC 102(b)(2). 4. Taxation of Forgiveness of Indebtedness. In the case of the gratuitous forgiveness of indebtedness, the Internal Revenue Code contains conflicting provisions relating to whether the donee has received gross income. See IRC 61(a)(2) and 102(a). It has been held that the forgiveness of indebtedness which is a true gift (i.e., made gratuitously and with donative intent) is not included in gross income. Helvering v. American Dental, 318 U.S. 322 (1943). D. Adjusted Basis Of Gifted Property. 1. Carry-Over Basis. The donee of property which is received in a lifetime gift transaction where no gain is recognized receives such property with a carryover of the donor's cost basis and acquisition date. IRC Basis for Gift Tax Paid. The basis of gifted property is increased for pre-1977 gifts by the gift tax paid. For gifts made after 1976, the basis of gifted property is increased by that portion of the gift tax paid attributable to the donor's net appreciation in the gifted assets. IRC Example: Assume that the donor gives stock having a basis of $200 and a fair market value of $1,000 to child, and pays $400 of gift tax. The basis adjustment for the gift tax paid is [(1000 minus 200)/1000] times $400, or $320. The donee's basis becomes $200 plus $320, for a total basis of $520.

9 ESTATE AND TRUST INCOME TAX ISSUES 3 3. Basis for GST Tax Paid. The basis of gifted property is increased (but not to above fair market value) by generation-skipping taxes paid. IRC This basis adjustment for GST taxes paid is applied after the basis adjustment for gift taxes paid pursuant to Code Section Basis of Suspended Passive Losses. Any suspended passive activity losses attributable to a gifted asset are added to the donee's adjusted cost basis and benefit the donee (although a dual basis may exist, and such addition to basis, to the extent it causes basis to exceed the fair market value of the property at the time of the gift, will not benefit the donee in a loss transaction). IRC 469(j)(6). Example: Assume that the donor has an asset with a fair market value of $100, an adjusted cost basis of $70, and a suspended passive activity loss of $40. When the asset is given, the donee will have a $100 basis for loss purposes and a $110 basis for gain purposes. 5. Limitation on Basis for Loss Purposes. For purposes of determining loss in a subsequent sale of a gifted asset by the donee, the donee's basis cannot exceed the fair market value of the gifted property at the time of its receipt by the donee. IRC This can result in the gifted asset having one basis for gain purposes and a different basis for loss purposes (i.e., dual basis). Example: Assume that a donor has an asset with a fair market value of $100 and an adjusted cost basis of $150. If such asset is gifted during life, and if no gift tax is due on such gift, then the donee will have a $100 basis for loss purposes and a $150 basis for gain purposes. No gain or loss would be recognized by the donee if the property is subsequently sold for more than $100 and less than $150. E. Loans to Family Members. 1. Below-Market Loan Rules. In order to avoid the adverse rules relating to below-market loans, which impute interest income and gifts to the lender if inadequate interest is charged, it is necessary to comply with the rules contained in Section 7872 of the Code. 2. Loans Under $10,000. No interest is imputed if the loan is $10,000 or less, and the loan proceeds are not used by the borrower for income producing investments. 3. Loans Under $100,000. No interest is imputed if the loan is $100,000 or less, provided that the borrower has no more than $1,000 of total net investment income. 4. Investment Income Limitation. If the loan is $100,000 or less, and the borrower does have investment income exceeding $1,000, then the imputed interest in any year will not exceed the borrower s net investment income for such year. 5. Loans at "Applicable Federal Rate" of Interest. On other loans, interest at the applicable federal rate (the "AFR") must be charged if imputed interest problems are to be avoided. Such rates are published monthly for short-term (0-3 years), mid-term (3-9 years) and long-term (9+ years) loans. III. INCOME TAX CONSEQUENCES OF RELATED PARTY TRANSACTIONS A. Who is a Related Party? Although the Internal Revenue Code has many different provisions dealing with related parties, Section 267 is the key section defining related parties which is used by most of the other sections which contain special tax rules for related party transactions. Complex attribution rules govern the determination of who is a related party. Pursuant to Section 267(b), related parties include: (1) Members of a family as defined in subsection (c)(4) [i.e., brothers and sisters (half-blood and wholeblood), spouse, ancestors, and lineal descendants]; (2) An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; (3) Two corporations which are members of the same controlled group (as defined in subsection (f)); (4) A grantor and a fiduciary of any trust; (5) A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts; (6) A fiduciary of a trust and a beneficiary of such trust; (7) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts; (8) A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of

10 4 ACTEC-ALI CLE PHONE SEMINAR MAY 9, 2013 the trust; (9) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual; (10) A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock in the corporation, or more than 50 percent of the capital interest, or the profits interest, in the partnership; (11) An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation; (12) An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or (13) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate. B. Section 1031 Exchanges Between Related Parties. Normally, taxpayers who do a Section 1031 exchange with each other don't care what the other party does with the exchange property after the deal is closed. However, if a taxpayer exchanges property with a related person in a Section 1031 tax-free exchange and within two years of the last transfer which was part of the exchange, either party disposes of the property received by that party in the exchange, then the original transaction does not qualify for the non-recognition of gain or loss under Section 1031 for either party. IRC 267, 1031(f). C. Sales of Depreciable Assets to Related Party. Gain on the sale of a capital asset is usually capital gain income (unless the recapture provisions contained in Code Sections 1245 and 1250 apply). However, in the sale or exchange, directly or indirectly, of property between related parties, any gain recognized by the transferor is treated as ordinary income if the property in the transferee's hands is depreciable property. IRC 267, D. Sale of Depletable Property to Related Party. Code Section 1239, which applies to the sale of depreciable property between related parties, does not appear to apply to depletable property. PLR (June 30, 1981). E. Appreciated Property Acquired By Decedent By Gift Within One Year of Death. In the case of a decedent dying after 1981, if appreciated property was acquired by the decedent within one year prior to the decedent's death, and if that property is subsequently reacquired from the decedent by (or passes from the decedent to) the donor of the property (or the spouse of the donor), then the original donor of the property will not receive a basis step-up at death. For example, a person owning highly appreciated assets could not give them to his or her terminally ill spouse and get a stepped-up basis if the assets were subsequently reacquired by inheritance within a year. IRC 1014(e). F. Disallowance of Losses on Sales between Related Parties. A loss can normally be claimed when investment property is sold at a loss. However, no loss is recognized on the sale or exchange of property between related parties (including a trust and its beneficiaries). An estate and its beneficiaries are not deemed to be related parties for this purpose when the transaction at issue if the funding a pecuniary bequest, so an estate (but not a trust, unless it had made a Section 645 election to be treated as a part of the estate) could recognize a loss if it funded a pecuniary bequest with loss property. Any disallowed loss is carried forward and can be applied to reduce the gain that would otherwise be recognized on the subsequent disposition of the property. IRC 267. G. Guarantee of Loans to Related Parties. Normally, a guarantor's payment on a debt will be deductible, either as a business bad debt or non-business bad debt. A parent's payment as guarantor on a child's liability will usually not be deductible by the parent. It does not matter in this case whether the deduction was a business bad debt or nonbusiness bad debt because Treasury Regulation Section (e) allows bad debt deductions only where the taxpayer received reasonable consideration for making the guarantee and provides that consideration received from a spouse or other defined family member must be direct consideration in the form of cash or property. See Lair v. Comm'r, 95 T.C. 35 (1990). H. Installment Sale to Related Party. Normally, a taxpayer who sells property on an installment basis does not care how or when the buyer of the property subsequently disposes of it. However, if an installment sale is made to a related party who subsequently resells the property before the original seller

11 ESTATE AND TRUST INCOME TAX ISSUES 5 has been fully paid (with a 2-year cutoff for property other than marketable securities), the sale by the related party accelerates the recognition of gain to the original seller. IRC 453(e). I. Non-Recognition of Gain or Loss Between Spouses. When one spouse enters into a sale transaction with the other spouse, the transaction is ignored for income tax purposes (i.e., no gain or loss occurs, so basis is unchanged). IRC J. Transfer for Value of Life Insurance. Life insurance proceeds are generally not taxed as income to the payee at the insured's death. However, if an existing life insurance policy is transferred for value to a non-excepted transferee (i.e., someone other than the insured, a partner of the insured, a partnership including the insured, or a corporation of which the insured was a shareholder or officer), then any proceeds realized in excess of basis will be income to the recipient. IRC 101(a)(2). IV. PRE-DEATH INCOME TAX PLANNING Discussion of tax planning for an individual with a shortened life expectancy requires considerable diplomacy. Most people faced with their own imminent mortality have a number of issues that are more important to them then minimizing taxes. Nevertheless, under the right circumstances, there are a number of areas that might warrant consideration by persons who have a shortened life expectancy. A. Capture Capital Losses. If an individual has incurred capital gains during the year, he or she may consider disposing of high basis assets at a loss during his or her lifetime, in order to recognize capital losses to shelter any gains already incurred during the year. As discussed below beginning at page 21, assets the basis of which exceed their fair market value receive a reduced basis at death, foreclosing recognition of these built-in capital losses after death. Moreover, losses recognized by the estate after death will not be available to shelter capital gains recognized by the individual before death. If, on the other hand, the individual has recognized net capital losses, he or she may sell appreciated assets with impunity. Net capital losses are not carried forward to the individual's estate after death, and as a result, they are simply lost. Rev. Rul , C.B. 52. B. Transfer Low Basis Assets to the Taxpayer. Since assets owned by an individual may receive a new cost basis at death, taxpayers may consider transferring low basis assets to a person with a shortened life expectancy, with the understanding that the person will return the property at death by will. This basis "gaming" may be easier in an environment with no estate tax or a substantial estate tax exemption. If the person to whom the assets are initially transferred does not have a taxable estate, substantial additional assets may be transferred, and a new basis obtained thereby, without exposure to estate tax. 1. Gifts Received Prior to Death. Congress is aware that someone could acquire an artificial step-up in basis by giving property to a terminally ill person, receiving it back with a new basis upon that person's death. As a result, the Internal Revenue Code prohibits a step-up in basis for appreciated property given to a decedent within one year of death, which passes from the decedent back to the donor (or to the spouse of the donor) as a result of the decedent's death. IRC 1014(e). A new basis is achieved only if the taxpayer lives for at least one year after receipt of the property Granting a General Power. Rather than giving property to a terminally ill individual, suppose that you simply grant that person a general power of appointment over the property. For example, H could create a revocable trust, funded with low basis assets, and grant W a general power of appointment over the assets in the trust. The general power of appointment will cause the property in the trust to be included in W's estate under Section 2041(a)(2) of the Code. In that event, the property should receive a new cost basis upon W's death. IRC 1014(b)(9). The IRS takes the position that the principles of 1 For the estate of a person dying in 2010 whose executor opted out of the federal estate tax, the modified carry-over basis rules of Section 1022 extended this look-back period to three years. For those estates, the denial of step-up applied regardless of whether the donor re-inherited the property. IRC 1022(d)(1)(C)(i). An exception to the three year rule applied to gifts received from the decedent's spouse, unless the spouse acquired the property from another person by gift within the prior three years. IRC 1022(d)(1)(C)(ii).

12 6 ACTEC-ALI CLE PHONE SEMINAR MAY 9, 2013 Section 1014(e) apply in this circumstance if H reacquires the property, due either to the exercise or nonexercise of the power by W. See PLR ( section 1014(e) will apply to any Trust property includible in the deceased Grantor's gross estate that is attributable to the surviving Grantor's contribution to Trust and that is acquired by the surviving Grantor, either directly or indirectly, pursuant to the deceased Grantor's exercise, or failure to exercise, the general power of appointment., citing H.R. Rept , 97th Cong., 1st Sess. (July 24, 1981)). If W were to actually exercise the power in favor of (or the taker in default was) another taxpayer, such as a bypass-style trust for H and their descendants, the result should be different. 2 C. Transfer High Basis Assets to Grantor Trust. An intentionally defective grantor trust is one in which the grantor of the trust is treated as the owner of the trust property for federal income tax purposes, but not for gift or estate tax purposes. If the taxpayer created an intentionally defective grantor trust during his or her lifetime, he or she may consider transferring high basis assets to that trust, in exchange for low basis assets of the same value owned by the trust. The grantor trust status should prevent the exchange of these assets during the grantor's lifetime from being treated as a sale or exchange. Rev. Rul , CB 184. The effect of the exchange, however, will be to place low basis assets into the grantor's estate, providing an opportunity to receive a step-up in basis at death. But for the exchange of these assets, the low basis assets formerly held by the trust would not have acquired a step-up in basis as a result of the grantor's death. At the same time, if the grantor transfers assets with a basis in excess of fair market value to the trust, those assets will avoid being subject to a step-down in basis at death. Since the grantor is treated for income tax purposes as the owner of all of the assets prior to death, the one-year look-back of Section 1014(e) of the Code should not apply to limit the step-up in basis of the exchanged assets. D. Change Marital Property Characteristics. For married clients living in community property jurisdictions, and for clients living in common law jurisdictions that have otherwise acquired community property, the clients may consider a modification of the marital property character of assets, if consistent with their dispositive scheme. 1. Partition Depreciated Community Property. If a married couple owns community property that is worth less than its basis, both halves of the community property will receive a step-down in basis upon the death of the first spouse to die. IRC 1014(b)(6). 3 Partitioning these assets into separate property will limit the loss of basis to only the deceased spouse's half of the assets. Additional basis could be preserved by having the terminally ill spouse transfer loss assets to his or her spouse in exchange for lowbasis assets. No gain or loss should be recognized from the exchange of those assets. IRC 1041(a). 2. Transmute Appreciated Separate Property. If local law permits the creation of community property by agreement, the couple should consider transmuting the healthy spouse's low-basis separate property into community property so that both halves of the property may receive a step-up in basis at death. IRC 1014(b)(6). 4 E. Dispose of Passive Loss Assets. If an individual has assets that have generated passive loss carryovers, he or she may wish to dispose of those assets prior to death, so that the losses can be deducted. The losses may otherwise be lost at death to the extent of any increase in the asset's basis. IRC 469(g). In addition, the IRS may take the position that the decedent s estate or trust does not materially participate in 2 For estates of persons dying in 2010 whose executors opted out of the federal estate tax, simply holding a general power of appointment over property would not be sufficient to cause the property to be treated as being "owned by the decedent" as required by the modified carry-over basis rules in Section 1022 of the Code. As a result, no part of the decedent's basis allocation could be used to increase the basis of these assets. IRC 1022(d)(1)(B)(iii). 3 For estates of decedents dying in 2010 whose executors opted out of the federal estate tax, this same result arose under Section 1022(a)(2)(B) because the decedent was deemed to own the spouse's half of the community property. IRC 1022(d)(1)(B)(iv); Rev. Proc IRB 188, For estates of decedents dying in 2010 whose executors elected out of the federal estate tax, the surviving spouse's share of the community property was deemed to be owned by and acquired from the decedent pursuant to Section 1022(d)(1)(B)(iv) of the Code, and as a result, was eligible for the $3 million spousal property basis increase. IRC 1022(c); Rev. Proc IRB 188, 4.01.

13 ESTATE AND TRUST INCOME TAX ISSUES 7 the activity after the client s death. See the discussion of this issue at page 13 below. Note, however, that the transfer of a passive-activity asset by lifetime gift does not trigger recognition of suspended passive activity losses for the donor. IRC 469(j)(6). Rather, any suspended passive activity losses attributable to a gifted asset are added to the donee's adjusted cost basis. This addition to basis provides some benefit the donee, although to the extent it causes basis to exceed the fair market value of the property at the time of the gift, will not benefit the donee in a loss transaction. To illustrate this limitation, assume that a donor has an asset with a fair market value of $100, an adjusted cost basis of $70, and a suspended passive activity loss of $40. When the asset is gifted, the donee will have a $100 basis for loss purposes and a $110 basis for gain purposes. IRC 1015(a). F. Pay Medical Expenses. It is not unusual for persons with a terminal condition to incur substantial medical expenses in the year of their demise. These medical expenses may be deductible for federal income tax purposes if they exceed 7.5% of the taxpayer's adjusted gross income. IRC 213(a). This threshold may be easier to meet in the year of the decedent's death, especially if the decedent dies early in the year before earning significant AGI, since there is no requirement to annualize income or make other adjustments to reflect a "short" year. Treas. Reg (a)(2). Expenses outstanding at the date of death, if paid within one year after the date of death, may be deducted on the decedent's final income tax return, or may be deducted as a debt on the decedent's estate tax return. IRC 213(c)(1). A "double" deduction is disallowed. IRC 213(c)(2). Note, however, that if the taxpayer actually pays outstanding medical expenses prior to death, they are eligible for deduction on his or her income tax return. At the same time, the individual's cash has decreased as a result of the payment, which has the same effect as deducting them on the estate tax return, since the decedent's estate is effectively decreased by the amount of the expenses paid. Even paying the medical expense by credit card prior to death should be sufficient to allow this double tax benefit. See Rev. Rul , CB 73. G. Accelerate Death Benefits. If a taxpayer is covered by a policy of life insurance, the taxpayer may seek to obtain a pre-payment of the death benefits available under the policy. If the payments are received at a time when the taxpayer is terminally ill or chronically ill, the payments may be excluded from gross income. IRC 101(g). The exclusion for prepayment of death benefits applies only to payments received from the insurance company that issued the policy, or from certain licensed "viatical settlement providers." A "viatical settlement" is a transaction in which a third party purchases the policy from the insured. 1. Payments to Terminally Ill Taxpayers. If the insured is terminally ill, payments are tax-free. This exclusion from income applies to both accelerated death benefits and to payments made by a viatical settlement provider (but only if the provider meets licensing or other requirements). IRC 101(g). For this purpose, a "terminally ill" individual is one who has been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death in 24 months or less. IRC 101(g)(4)(A). 2. Payments to Chronically Ill Taxpayers. If the insured is chronically ill, payments are tax-free only if detailed requirements are met. For example, the payment must be for costs incurred for qualified long-term care services. These costs include both medical services and maintenance or personal care services provided under a prescribed plan of care. Also, the payment must not be for expenses reimbursable under Medicare, other than as a secondary payor. IRC 101(g)(3). A person is considered "chronically ill" if he or she is unable to perform, without "substantial assistance," at least two activities of daily living for at least 90 days due to a loss of functional capacity. See IRC 101(g)(4)(B); 7702(c)(2)(A). The exclusion for chronically ill taxpayers is subject to a per-diem cap ($300 per day, or $109,500 per year for 2011). IRC 101(g)(3)(D); 7702B(d); Rev. Proc , IRB

14 8 ACTEC-ALI CLE PHONE SEMINAR MAY 9, 2013 V. INCOME TAXATION OF DECEDENTS AND ESTATES A. The Decedent's Prior Tax Returns. Upon the death of an individual, the personal representative should determine which income tax returns have or have not been filed by the decedent, and examine those returns, in order to ascertain whether all required returns have been properly filed. 1. Ascertaining What Tax Returns Have Been Filed. The IRS can provide information about whicht tax returns have been filed by the decedent. The executor should make a written request for a "Record of Account" from the appropriate region. The executor's letters of appointment (and a Form 2848 Power of Attorney if the executor's attorney is to get the information) should be included with the request. The IRS response will be supplied free of charge. Call for details. 2. Ascertaining the Amount of the Decedent's Income. The executor may not be certain that he or she has information concerning all of the decedent's income relating to years for which the executor will file income tax returns on behalf of the decedent. It may be necessary to request in writing "All Information Returns" (you should be as specific as possible) in writing from the appropriate region. Information is available after August 1 st relating to the prior year, and six years' worth of information is kept in the IRS computers. Again, the executor's letters of appointment (and a Form 2848 Power of Attorney if the executor's attorney is to get the information) should be included with the request. The IRS response will be supplied free of charge. The executor can call for details. 3. Getting Copies of Prior Filed Tax Returns. The executor can obtain copies of prior income tax returns filed by the decedent from the IRS via Form Consider requesting at the same time copies of gift tax returns filed by the decedent. Be sure to make your request to the proper region or district, based upon where the decedent filed the returns in question. The executor's letters of appointment (and a Form 2848 Power of Attorney if the executor's attorney is to get the information) should be included with the request. The IRS response will require a fee ($57 per return the last time the authors checked). 4. Contact Area Disclosure Officer. Any questions concerning what information is available from the IRS, or procedurally how to get at that information, should be directed to the IRS Area Disclosure Officer. Personnel in this office are generally very knowledgeable and helpful with regard to these matters B. The Decedent's Final Return. Upon the death of an individual, a final income tax return must be filed. In fact, depending upon the date of death, there may be two returns required for the decedent one for the last full calendar year of the decedent's life, if that return was not yet filed as of the date of death, and one final return for the year of the decedent's death. Only this last return is the "final" return. The final return of the decedent includes items of income and deductions actually or constructively received or paid (assuming the decedent was on a cash basis) by the decedent prior to death. Treas. Reg (b). The responsibility for preparing and filing the decedent's final income tax return rests with the personal representative of the estate. Treas. Reg (b)(1). 1. Due Date, Filing Responsibilities, and "Short Year" Issues. A decedent's final return is due on the regular return date, typically April 15th of the year following the date of death. Treas. Reg (b). The executor need not make adjustments to reflect a "short" year. Treas. Reg (a)(2). Apparently, the personal representative need not make further estimated tax payments on behalf of the decedent. Although Code Section 6153, which formerly dealt with estimated payments, has been repealed and replaced by Code Section 6654, the IRS has privately ruled that the principles set forth in Treasury Regulation Section (a)(4) (which exempted estates from making estimated payments) continue to apply to Section 6654 (for which there are no relevant regulations). PLR Estates (and certain post-death revocable trusts) are exempt from the requirement to make estimated tax payments for two years. IRC 6654(l)(2). While the surviving spouse must generally continue to make estimated payments, there is no longer any requirement to file an amended declaration of payments. See former IRC The executor of the estate is responsible for paying the decedent's income tax liability. The distributee may also be held liable. IRC If no executor is appointed, the term "executor" means any person in actual or constructive possession of any property of the decedent. IRC The

15 ESTATE AND TRUST INCOME TAX ISSUES 9 executor faces personal liability if he distributes the estate prior to paying tax obligations of which he had notice, or with respect to which he failed to exercise due diligence. Treas. Reg (b)-2(a); IRC 6012(b)(1). 2. "Fiduciary Liability". Pursuant to the concept of "fiduciary liability," the executor is personally liable for the income and gift tax liability of the decedent, at least to the extent that assets of the decedent come within the reach of such executor. 31 U.S.C. 3713(b). Fiduciary liability may be personally imposed on every executor, administrator, assignee or "other person" who distributes the living or deceased debtor's property to other creditors before he satisfies a debt due to the United States. a. Insolvency of Estate. Fiduciary liability is imposed only when, by virtue of the insolvency of a deceased debtor's estate or of the insolvency and collective creditor proceeding involving a living debtor, the priority of 31 USC 3713(a) is applicable. b. Limited to Distributions. The fiduciary's liability is limited to debts (or distributions) actually paid before the debt due to the United States is paid. c. Knowledge Required. The fiduciary must know or have reason to know of the government's tax claim. d. Deferring Distributions. Fiduciaries will frequently delay making distributions until they are no longer liable for the decedent's income tax and estate tax liabilities. Refunding agreements with beneficiaries and state law provisions allowing fiduciaries to get back prior distributions to settle estate liabilities are sometimes relied upon, but require that the beneficiary still have the funds to refund to the estate. 3. Transferee Liability. Transferee liability may make the transferee: (1) of property of a taxpayer personally liable for income taxes, (2) of property of a decedent personally liable for estate taxes, and (3) of property of a donor personally liable for gift taxes. IRC a. Transferee Liability at Law. Transferee liability at law exists under Section 6901 of the Code if the government can prove: (1) the taxpayer transferred property to another person; (2) at the time of the transfer and at the time transferee liability is asserted, the taxpayer was liable for a tax; (3) there is a valid contract between the taxpayer who is the transferor and the transferee; and (4) under the terms of that contract, the transferee assumed the liabilities of the taxpayer, including the obligation to pay the tax or specifically the obligation to pay the taxes of the transferor. b. Transferee Liability in Equity. Transferee liability at equity exists under Code Section 6901 if the government can prove: (1) the taxpayer transferred property to another person; (2) at the time of the transfer and at the time transferee liability is asserted, the taxpayer was liable for the tax; (3) the transfer was made after liability for the tax accrued, whether or not the tax was actually assessed at the time of the transfer; (4) the transfer was made for less than full or adequate consideration; (5) the transferor was insolvent at the time of the transfer or the transfer left the transferor insolvent; and (6) the government has exhausted all reasonable efforts to collect the tax from the taxpayer transferor before proceeding against the transferee. 4. Priority of Tax Claims. In a probate setting, the state law rules relating to the time and place for filing claims do not apply to the tax claims of the United States. Board of Comm'rs of Jackson County v. U.S., 308 US 343 (1939); U.S. v. Summerlin, 310 US 414 (1940). Federal law generally provides that a debt due to the United States be satisfied first whenever the estate of a deceased taxpayer/debtor is insufficient to pay all creditors. 31 USC 3713(a). Although no exceptions are made in Section 3713(a) of the Revised Statutes for the payment of administration expenses, the IRS nevertheless appears to recognize exceptions for administration expenses, funeral expenses, and widow's allowance. GCM 22499, CB-272; Rev. Rul CB Claims for Refund.

16 10 ACTEC-ALI CLE PHONE SEMINAR MAY 9, 2013 a. Time for Filing. A tax refund claim must generally be filed within three years from the time the related return was filed or two years from the time the tax was paid, whichever of such periods expires later, or if no return was filed, within two years from the time the tax was paid. IRC 6511(a). Special rules extend the time for filing a claim for refund in cases where the period for assessing tax has been extended and in other cases. IRC ' 6511(c); 6511(d). Equitable mitigation provisions exist that may be useful in cases where a refund or credit would otherwise be barred by the applicable statute of limitations. See IRC ' ; b. Informal Claims. In estates with no formal need for administration, a surviving spouse, heir, or another person agreeing to pay out the refund according to the laws of the state where the decedent was a legal resident may claim any refund owed to the decedent by filing IRS Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer. 6. Place for Filing Decedent's Final Return. The final Form 1040 should normally be filed in the Internal Revenue District in which the legal residence or principal place of business of the person making the return is located (i.e., based upon where the executor is located, which is not necessarily where the decedent filed his or her returns), or at the service center serving such internal revenue district. IRC 6091(b)(1)(A); Treas. Reg (a). If the person filing the return has no legal residence or principal place of business in any Internal Revenue District, the return should be filed with the District Director, Internal Revenue Service, Baltimore, Maryland, 21202, except as provided in the case of returns of taxpayers outside the United States. Treas. Reg (a). The return made by a person outside the United States having no legal residence or principal place of business in any Internal Revenue District should be filed with the Director of International Operations, Internal Revenue Service, Washington, D.C , unless the legal residence or principal place of business of that person, or the principal place of business or principal office or agency of such corporation, is located in the Virgin Islands or Puerto Rico, in which case the return shall be filed with the Director of International Operations, U.S. Internal Revenue Service, Hato Rey, Puerto Rico Treas. Reg (c). 7. Applicable Statute of Limitations. Income tax must normally be assessed within three years after the related return was filed, whether or not such return was timely filed. IRC 6501(a). The normal three year income tax statute of limitations is extended to six years if the taxpayer makes a substantial omission (in excess of 25%) of the amount of gross income shown on the return. IRC 6501(e)(1). There is no limit on the statute of limitations where a false return was filed, there is a willful attempt to evade tax, or no return was filed. IRC 6501(c). The normally applicable statute of limitations is extended as to transferees for one year in the case of the initial transferee, and as to transferees of transferees, for as much as three years after the expiration of the period of limitations for assessment against the initial transferor. IRC 6901(c). The taxpayer and government can agree to indefinitely extend an income tax (but not estate tax) statute of limitations prior to the expiration of the statute. IRC 6501(c)(4). a. Requests for Prompt Assessment. The executor may shorten to 18 months the period of time for the IRS to assess additional taxes on returns previously filed by the decedent or the executor by separately filing Form Treas. Reg (d)-1(b). It is not believed that this increases the audit exposure on such returns. b. Requests for Discharge from Personal Liability. The executor may request a discharge from personal liability for estate, income and gift tax liabilities of the decedent (which gives the IRS nine months to collect such taxes from the executor) by making a request for such a discharge (Form 5495) pursuant to Code Sections 2204 (as to estate tax), or 6905 (as to income and gift tax). This request does not shorten the statute of limitations (i.e., the IRS could still assert the tax due by pursuing the assets, transferees, etc.), and it is not believed that this increases the audit exposure on such returns. 8. Filing Joint Returns. The personal representative has the option to file a separate return for the decedent, or to file a joint return with the surviving spouse, provided that the surviving spouse has not remarried prior to the end of the survivor's tax year. IRC A joint return may not be filed if either of the spouses is a nonresident alien at any time during the taxable year. IRC 6013(a)(1). If no executor has been appointed by the due date of the decedent's final return, the surviving spouse may file the joint